To Fee or Not to Fee: What Banks Need to Know About Overdraft Fees & Overdraft Programs

No one likes fees. And few fees make people more angry than banking fees. Many financial marketers may just chalk it up to human nature and say there's nothing that can be done.

As the frustration has grown in the industry, overdraft fees have gone (and returned from) death's door more than a few times. Many financial institutions are walking away from the fees or severely cutting them are a very small percentage of the overall industry, but they include some of the biggest names in banking.

So far, most institutions are holding onto their fees, such as Bank of America and Wells Fargo.

However, the pressure to change — coming from digital bank competition from the likes of Chime, Varo and Ally, as well as from increased government scrutiny — is prompting the most sweeping changes to these long-criticized fees ever seen.

The most recent news in the world is Bank of America's 90% reduction in overdraft fees. Doesn't bode well for the future of the revenue stream.

"In the early 2000s, overdraft was kind of the Wild West of revenue for banks and credit unions."

— Steve Swanston, Velocity Solutions

The way overdrafts work in banking has come a long way over the years. Let's dive in.

Why the Overdraft Fee is Dying

Interstingly enough — as annoyed as customers get — there is something that can be done to save the overdraft fee. Most of the time (if not all of the time), it's ultimately a necessary evil for bankers who want to ensure customers that need overdraft protections have access to them.

There is a bigger question hovering in the background of the overdraft fee conversation: What is the underlying reason people don't like banking fees? Millions of people pay monthly charges for services that are far less important than their bank account: Netflix, Amazon Prime, cable, mobile phone, toll booth passes, etc.

Oddly enough, according to McGuffin Creative Group research, people do find some of banking's traditional fees (like overdrafts) to be fair.

In fact, some of the consumers the marketing consulting firm spoke to could even cite why banks and credit unions charge fees in the first place.

McGuffin's Senior Marketing Executive Danielle Filippone and Partner Betsy Fiden told The Financial Brand they conducted the survey because they saw a disconnect between how financial institutions perceived themselves and how customers thought about their banking provider. Filippone says the report was born out of their curiosity over one big question: "Do customers even see banking as a 'service'?"

Even for those that do accept fees as an inherent part of the banking system, there are only some services for which they consider fees to be fair to charge versus what they think should be free, such as mobile banking.

So, if people are fine with overdraft fees, why are hundreds of banks and credit unions reconsidering them?

The uproar over fees — particularly overdrafts — can be attributed to several factors. Among them from the consumer's perspective are the high cost for what is often considered to be an oversight, paying multiple fees for one infraction, or simply annoyance at these penalty fees.

Know Your Customer Base:

Financial marketers may assume people are upset about all banking fees, but there are some fees that people consider more fair than others.

Distinguish Between NSF and Overdrafts

One of the challenges regarding the whole issue is there is a misunderstanding of the difference between a non-sufficient fund (NSF) fees and overdraft fees. It even exists within the industry and certainly does among most consumers.

While a customer is charged an NSF fee when a bank declines to pay a transaction due to insufficient funds in the customer's account, an overdraft fee signals the bank paid the transaction despite the overdrawn amount (as Velocity experts explain it).

"It's really the NSF fee that has been hit [by most of the recent changes], even though to the naked eye, NSF and overdrafts are considered the same thing," Swanston says. Regardless, that shouldn't be the sole focus of banks and credit unions.

"Customers still willingly use overdraft service, and there is an optimal point where the value of the service matches up with what the consumer perceives to be the fee they're willing to pay."

What Financial Institutions Can Do About Overdrafts

It might seem like a good idea to fall in line with the trends, knock out altruistic automatic overdraft programs and get rid of the fees altogether. For some institutions, it might be.

But for smaller community banks and credit unions, it may actually be quite detrimental.

Not a Good Option:

Aside from causing a big hit to a bank's revenue, nixing overdrafts altogether will drive some consumers to high-cost lenders.

"Regulators do not want consumers leaving the regulated banking system to meet short-term liquidity needs, as they routinely do now by going to payday lenders, pawnshops and online alternative lenders," says Christopher Leonard, CEO of Velocity Solutions, a provider of algorithm-based liquidity solutions.

He says that overdraft arrangements shouldn't be jettisoned altogether — many consumers actually like having the option.

"We believe that the current overdraft environment sets up a new competitive landscape where community financial institutions can win against large banks by offering real liquidity to consumers based on ability to repay, whether that's through overdraft or through small-dollar short-term lending," Leonard says.

Fiserv's Jeff Burton describes the overdraft situation as "getting a facelift." Burton, who is VP of Product Management for Deposit Liquidity Solutions, says "It's hard to imagine financial institutions will eliminate paying items into overdraft completely."

He maintains that analyzing and determining repayment risk is the best alternative. "Ignoring this risk by offering either fixed limits or not addressing the limit strategy currently deployed would be a potentially costly mistake."

Break Out of the Habit:

Instead of giving customers the same threshold, use data to learn how much of an overdraft the customer can repay.

Leonard says that many people would rather have overdraft protections in place, even if it requires a fee.

"For those consumers, we should be more focused now on technology that can automatically taper overdraft fees when consumers are not able to afford them based on their income," he says, adding that underwriting a customer's ability to repay overdrafts is crucial.

Take a Look at Some Overdraft Revamp Banking Pros

Justin Hayden (managing principal at consulting firm Capco) told S&P Global Intelligence that because community banks are not under a microscope like large banks, they can take more nuanced approaches. For example, some offer one account with zero overdraft fees as an option rather than targeting all accounts.

Seeing the writing on the wall and taking a cue from large institutions, many community banks and credit unions are re-evaluating their overdraft fees and policies. Here are a few specific examples:

Atlanta-based Ameris Bank announced in March 2022 the elimination of NSF and overdraft fees in most cases. The southeastern regional bank with $24 billion in assets is able to weather the fee reduction.

Jovia Financial Credit Union is much smaller, at $4 billion in assets, and yet it also did away with traditional overdraft and NSF fees. The New York-based credit union replaced overdrafts with a new account, CareFree Checking, that also has no monthly maintenance fee or minimum balance requirement.

In April 2022, Iowa's MidWestOne Bank announced Overdraft Flex, a new policy that enables customers to avoid a fee when the overdraft is $50 or less. In addition, they will incur no charge for an overdraft of $5 or less, and the maximum number of daily overdraft fees has been reduced from five to four. MidwestOne Bank has assets of about $6 billion.

Leonard suggests that it's not always about getting rid of the fee altogether. Instead, it should be about education.

"I had a bank executive whose institution competed in Capital One's market area ask me, 'How do I respond to a customer who wants to know why we're still charging an overdraft fee when Capital One is not?'" Leonard suggested that the banker tell customers to call Capital One and ask how much they will cover if an account gets overdrawn.

The banker could then say: "They probably won't even tell you, and if they do, it's likely to be an extremely small number. Our community bank will cover hundreds of dollars of items, maybe more, and we'll clearly tell you how much we will cover for you this month based on the activity in your account."